The Most Important Thing to Do BEFORE You Walk Away From Investment Property


This post is in: Real Estate
22 Comments

5-12-1If you or someone dumped bad real estate, then there might be a ticking tax bomb coming your way. It’s a Form 1099-C and it means you have cancellation of debt. Cancellation of debt is taxable.

So if the lender takes your property from you, or do you a short sale, chances are the current value is less than your loan. That means the lender has to forgive part of the debt or may pursue you for the difference.

If they forgive the debt, you have cancellation of debt. And if you have cancellation of debt, you have a taxable event.

The amount of debt that is cancelled is taxable income to you. You report it on your Form 1040 just like any other type of ordinary income. In other words, you never got a check, but you have to pay tax on it.

5-12-2So, let’s go with the foreclosure or short sale scenario and assume that your lender has forgiven debt. Just as a note, though, don’t assume that the lender is forgiving all debt. In most states, they can pursue you if you’ve refinanced the first loan or for a second mortgage. And depending on your particular state laws, they could wait years to come after you for the amount. Yikes!

Anyway, for purposes of this blog, we’ll assume that the property shortfall is forgiven.

Example: You bought a property for $500,000 with a $450,000 mortgage. It’s foreclosed on and sold for $200,000. The lender forgives the debt of $450,000. You have to pay tax on $250,000 ($450,000 – $200,000).

But don’t panic quite yet. If it’s a rental property, you’re going to have some loss too. Let’s keep it simple and assume that there is no depreciation.

You have effectively sold the property for $200,000. Your basis was $500,000. That means you have a loss of $300,000.

Sell it as a rental property:
Taxable income of $250,000. Loss of $300,000. You end up with a net loss.

That’s all the preamble to the big tax issue: Investment property that has not yet been put in service.

If the property is just sitting there, it’s a capital loss when you lose it, not an active real estate property.

Sell it as an investment property:
Taxable income of $250,000. Capital loss of $3,000. You end up with net income.

USTaxAid Solution: Put the property in service before you walk

5-12-3If you walk on property too quickly, you’ll pay as much as $40,000 in extra taxes. That one little piece of advice “Put the property in service before you walk” can save you BIG TIME!

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22 Comments

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  2. Diane Kennedy says:

    Mike,

    I know your situation is far from funny, but I have to say the way these lenders are coming up with crazy numbers is hilarious. It seems like they are either putting $0 as FMV or they’re putting a super-high inflated value. And ever so often, they put the right amount.

    But, in your case, the rules are pretty clear – you have a disposal of a property that shows a FMV of $0. Plus you have COD income of $44K that will be taxable. My guess is you will have a loss on the disposal of property. Or you may be able to claim the insolvency or bankruptcy exemption.

  3. Mike says:

    Great site. I did a deed in lieu last year on a rental property. The lender sent a 1099C, they put $0 in box 7. When I called the lender, they told me that since they(the lender)still has possession of the property that box 7 should read $0. The amount of debt canceled is 44k. How do I calcuate the taxable amount without a FMV in box 7?

  4. LT says:

    Diane and Jeff, thank you for the comments.

    I failed to mention we demolished the house in 2010, so there is nothing but an empty lot. I am not sure they have even checked since they have the FMV listed as $35K.

    (Another thing we should not have paid for, the demo…live and learn I guess.)

    I am curious, does the cost of the demo (our city sued us to get this done), get to be added to the loss (added to basis)?

    I will stay with the property being a non-primary residence for tax purposes.

    I am still looking for a decent tax preparer. I have done my taxes my whole tax paying life and use to be a preparer in the 80’s for others. I have not stayed on top of all the changes though and this was a totally new area for me.

    The two places I stopped and tried to get info on all of this literally had no clue. One was Liberty and one was a private owned place.

    My daughter just got a position with a major chain as the recep/scheduler, so I may check with them.

    You and this site has been a wealth of knowledge for me and I thank you.

    Be well.

  5. Diane Kennedy says:

    I don’t want to add more complications to your already confusing situation, but there are a few decisions that you will need to make.

    (1) If the property is considered a primary residence, then you most likely will not have tax on the Form 1099-C. This depends on when they give you the form and what the laws are at the federal and state level at that time.

    (2) If we take the position the property is an investment property (because you had rented it out), then you can take a loss on the disposal of the property. You will owe tax on the income from the Form 1099-C. But most likely the loss will more than offset the income.

    As far as FMV, it should be the FMV at the time that the property was taken back. So, it wouldn’t be based on the value of houses, it would be based on the value of a burned out house on land. That actually could be less than the value of the land because of the costs needed to remove the structure.

    You have some decisions to make here on how you want to proceed. You probably have justification for the argument that the property was a principal residence or that it was an investment, so it’s time to discuss that with your tax preparer and figure out where to go from there.

  6. LT (baffled Mum) says:

    Hello again,

    As to info, here goes:
    The numbers I stated from the 1099-A are correctly copied in my post. The balance of loan is less then their stated balance of FMV.

    I am not sure if FMV means what we could have sold the house for, but if so, that would have been between $115,000.00-$120,000.00. Yes house prices here are not what they are in California as that is where I moved to TX from in 1998. 🙂

    At the time of foreclousure, the lot was worth about $20,000.00, however there were very few lots left in this city, but with the resession, not a good time, so who knows.

    I believe our purchase price in Mid-1998 was $79,500.00 and we added a house AC unit, and rebuilt the outside of the fireplace due to water damage and the front of the house entrance as well. (Probably about $10K in inprovements) Since my husband is a contractor so we just have the material fees, as he did the work.

    “and any original and subsequent financing.”

    Not sure about this part. We originally bought it with $20K down and a balloon loan due in 5 yrs. We paid P&I, and T&I seperately. We refinanced in about 2003 to a 15 yr. note.

    After the fire the original bank sold the mortgage to ABMI or some entity. About a year later it was sold again to Citi where it stayed.

    We were billed for forced insurance, even though the place was uninsurable due it being burned, from the time it was first sold to the ABMI entity. CitiMortgage did at least review the photos and reports we sent them and reduced the amount we paid insurance on, but it was still a scam on their part. It was just insurance for them if we walked away, not a plan that covered anything since the place was already condemned.

    To make matters even more fun, our city enacted an ordinance that allowed them to write us a citation for a residence “visually not up to code”. Each time they cited us the fee was $281 plus court costs. That went on for about a year! 🙂 Again, I digress…so easy these days!

    The city wanted us to demo the house. We were hoping the insurance co, and/or the electric co. would do the right thing so we could rebuild, or depending on when it happened, demo it, pay off the loan and decide what to do…we never got to make that choice however… 🙂

    In researching the IRS pages and Publications, (525, 544 & 4681) I think I do the following:

    Nothing until I get a 1099-C, tax wise.

    Locate all the receipts we have for the property, find the actual purchase price, locate any points and other loans “thingies” we had to pay and after totaling I will have my “basis”.

    Subtract the amount CitiMortgage has cancelled from that amount and I have the loss I can claim in the amount of $3000.00 per year, yes?

    Not sure which forms I will need, or where the loss needs to go on the 1040 pages, but I will cross that point when I get there.

    *I did not take a loss due to the fire at all.

    *This property WAS our first house here, but we purchased the home, where we live now, in 1999 and never lived in the “burned” house again.

    *We did rent out the house throughout the years off and on before the fire.

    *We did not take any depreceation (spelling?) on the property ever.

    * I figured out the rent income each year for tax purposes when it was rented, but we never made any profit, so there was no reportable income.

    If I need to give you more info, please let me know.

    Thanks for all the help again.

    LT

  7. Jeff Johnston says:

    Dear, Baffled Mum.

    I feel badly how your situation ended. From a tax perspective, I’m curious if Diane was addressing the casualty loss deduction, a capital gain(loss) issue, or avoiding cancellation of debt income (CODI). Those are three distinct tax issues, all of which should be analyzed separately.

    But first, is it a typo in your posting that the balance outstanding on the loan is LESS than the FMV? Did you really only owe that little on your principal residence? (Maybe I’m jaded being in California.) If the numbers really are correct, seems there’s nothing to worry about CODI, and only a concern of whether you can take a casualty loss for the loss of your equity. A casualty loss can be deductible as a principal residence, but not a capital loss if it was your residence.

    Diane also discusses the question of whether it was a principal residence, a capital asset not used as a residential rental, or a rental that’s actually placed in service. That sounds like a capital gain(loss) discussion, which is yet another point altogether.

    I’d like for you to verify the numbers mentioned in each block of the 1099-A, estimate the FMV at the time of the fire and at the time of foreclosure, and tell us about your original purchase price, any major improvements (not maintenance), and any original and subsequent financing. There’s just not enough information in your post to advise you in all three areas that really should be discussed.

    Don’t forget that you must reduce your basis for capital gain(loss) purposes by whatever casualty loss that you deduct, any reimbursement you received from the insurance company or electric company that relates to the real property (not including personal property, unless attached since that makes it real property), and any CODI exclusion, if there were any forgiveness of indebtedness (regardless of the subdivision under IRC § 108(a)(1) that applies.)

    Give us detailed of information on all of the above and then Diane and others can help you with far greater specificity and less room for error due to miscommunications.

    Just my two cents, even though that’s not worth much these days. 😉

    Major kudos to Diane and her staff for providing such great expertise and a wonderful resource to the public.

    Jeff

    Jeff Johnston, J.D., LL.M.* (Tax)
    Principal, Johnston Tax Group
    Federal and state tax matters

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  8. Diane Kennedy says:

    BREAKING NEWS! We’re doing a FREE teleseminar; “You got a Form 1099-A (or C) – Now what?” It’s on Sat 2/5/11 at 9 am. Please register at http://www.DianesSeminars.com

  9. Diane Kennedy says:

    LT (Baffled Mum):

    First of all, I’m sorry this happened to you. It might be legal (and then I’m not sure about that), but it’s certainly not fair.

    The best way to have handled this loss would have been to take it in 2006. Then if you receive insurance money, you amend for the insurance money received or possibly report in the year you receive it as extra income.

    But that’s water under the bridge. What you have now is a property with a basis that has been disposed for less basis. The question is if this is a primary residence, an investment property or a property put in service.

    It sounds like you moved out of the property, so it’s not a primary residence (good news). If it’s an investment property (not put in service),you’re going to have a capital loss which means $3,000 per year allowed. Still, that’s better than nothing.

    It doesn’t surprise me that you didn’t get a Form 1098, the lenders can’t seem to get most of the documents right these days.

    Next steps:

    Figure out what your basis in the property is. That would be what you paid, less depreciation (if any) plus major improvements.

    The Form 1099-A will show a FMV, use that as your ‘sales price’. The basis is your basis. The difference is your loss. That loss is then deductible.

    As far as the Form 1098 interest, if you did pay interest in 2010 (ie, made payments on the property), you will need to calculate how much interest it was and then take the deduction. Include a statement including the lender’s name, address and EIN if you can find it from previous years. Explain in the statement that the lender refused to provide a Form 1098.

    Hope that helps!

  10. LT says:

    I got a 1099-A today and box 2 = $34186.34. Box 4 = $36575.00.
    Long story short, this is an empty lot with an appraised value of $12K. Our house burned in ’06, and after 3+ yrs of fighting with electric company(which did not turn off power when directed) and insurance company (which found a clause so they didn’t feel they needed to pay), a judge through out the case cause “she could”, as she said.

    We lost all equity obviously. I paid all mortgage, insurance (forced) and property taxes from the date of fire through the case getting tossed and then said, “Enough”.

    We tried a short sale, one offer for $20K, but the mortgage company dragged their feet so long, the buyer went away.

    Now I get the 1099-A, but did not get a 1098 to show the interest I paid through Sept. 2010.

    I have gotten different answers from tax preparers and nothing from reading instructions on irs website for 1099-A.

    Please tell me what I am suppose to do. We already lost about $85K of equity in the house, spent close to $30K over the 3+ yrs after the fire and to think I need to report $34+K as income is mind boggling.

    *Note, I did not take a loss of the fire becuase I thought the insurance co. was going to do the right thing. That deadline past for loss on 14 April 2010 I was told by IRS.

    Thanks in advance for any answers.

    Baffled Mum of 3 and maker of about $30K a year.

  11. Rick says:

    If borrower owes $60,000, and it is sold at foreclosure sale (public auction) where the lender bids in the full debt of $60,000 at the sale, and the lender later resells the property for $40,000, is there $0 or $20,000 forgiveness of debt?

  12. Scott Francis says:

    Diane,

    This is great information and very timely.

    Would the same formula apply to an investment property with a non-recourse loan?

    Thanks

  13. Diane Kennedy says:

    Frank, if you rented a property prior to the short sale and can prove it with a Schedule E – AWESOME! Yes, it is clearly put in service.

  14. Diane Kennedy says:

    Marco, if it sells as an investment, that means a capital loss and unfortunately, that means capital loss rules. You can take your capital loss against capital gains and then just $3K of the excess. So, yeah, it’s just $3,000 per year.

  15. Hey Diane,

    A very good article.

    Did you mean to say a “Capital loss of $300,000” if selling it as an investment? It might be just a typo, but you have “$3,000”.

    Thanks for the clarification Diane.

  16. Frank says:

    Thanks, Dianna, for the point you are making in the article.

    “That’s all the preamble to the big tax issue: Investment property that has not yet been put in service”

    So the question is how does anyone to put a rental property “in servie”? would active rental agreement and been reported on Schedule E last year prior to short sale would be suffcicent?

  17. Jeff says:

    > “In many states, there is no protection against deficiency judgments on a 2nd mortgage. Actually, I can’t think of any state that DOES give that protection.”

    At least in California, protection is afforded based on the character of the second mortgage, not on the order of lien position.

    In other words, using a HELOC for the *purchase* of a property still makes it a “purchase money mortgage” despite its second lien position or the fact that it’s an open line of credit.

    I believe the same is true for deductibility of mortgage interest for federal tax purposes. “Acquisition indebtedness” can be a HELOC when the HELOC was drawn upon for the purchase of the property.

    That distinction may seem inconsequential, but most of the 80/20 loans done in the past five years are likely this very scenario, whether the second be a line of credit or a fixed term loan.

    (CYA: This information is presented based upon my experience as a licensed real estate broker and is not intended as legal advice. You should consult a licensed attorney in your state to determine the correct tax status and legal remedies applicable to your particular facts.)

  18. Diane Kennedy says:

    Wow, great question.

    The 2nd wouldn’t issue a Form 1099-A because they didn’t get any property. In many states, there is no protection against deficiency judgements on a 2nd mortgage. Actually, I can’t think of any state that DOES give that protection.

    If there is no protection, it’s possible that the 2nd lien holder is determining whether there is any point in pursuing an action against the owner.

    If you go ahead and take the position that there is COD on the 2nd (without a Form 1099-C), will there be enough loss on the property to offset?

    Then later if the lender writes off the loan, they will issue a Form 1099-C in that year. You’d then need to state that it was taken in a previous year.

    Or the lender may never issue a Form 1099-C and so you never deal with the issue.

    When all is said and done, as a preparer, I would lay out all the options and then probably recommend to NOT report the income in the current year. There will probably be a loss ont eh property that will offset other active income or maybe even be a loss carryforward. But also caution the taxpayer that this could come back to bite them, so be ready.

  19. Byron Green says:

    I was at a tax class yesterday, and some of the discussions were about short sales and foreclosures. One discussion had to do with a business rental short sale in 2009, having the first mortgage paid off through escrow, and only 1% of the second/equity line loan paid through escrow. The second/equity line loan is still open and due. The bank/mortgage company has not determined the status yet. No Form 1099C or 1099A has been received on the second/equity line loan for 2009.
    > Does it make sense for the taxpayer to record the relief of debt on the second/equity line loan in 2009, even without the Form 1099, in order to offset the ROD ordinary income, with the business loss on the sale of the rental property? Any thoughts on this issue?

  20. Great article, Diane — thanks! Because of a law change in NY, I had to re-register as a CPA and now must complete CPE . . . this, after years of being “inactive” while pursuing art. Ah well. So I’ll probably be reading your blog more in the future!

    Keep it coming!